Thursday, September 18, 2008

The Fed Proposes Insurance for Money Market Funds

This is clearly an historic period in global financial market history. Virtually anyone with a substantial portion of his portfolio in equities has taken a hit. One thing that has allowed me to sleep nights is having gone through a few bear markets before. However, almost no one alive has ever experienced markets like these. Perhaps the most important reason I have been able to sleep nights is that about half my portfolio is not in the stock market. I invest the “safe side” of my portfolio primarily in government bonds, and government insured certificates of deposit – and money market funds. Yesterday, I sold the money market funds.

Under normal circumstances, money market funds are safe. They buy short-term debt instruments, including commercial paper (short-term loans to businesses). In the history of these funds, almost no one has lost money by investing in them. However, these are not normal circumstances, and money market funds do not come with government guarantees. As a result, in the last few days, investors have moved over $200 billion from money market funds to safer harbors. I didn’t want to be the last one out.

(much of) The Economy Depends On Money Market Funds

The money market industry is now a $3 trillion industry. Commercial paper has replaced bank loans for many purposes. The question I asked my broker was, “How can the economy continue to function if there is no money available to buy commercial paper?” Based on government actions today, I think the Fed’s answer is “It can’t.” The Fed’s action to insure money market funds will help prevent the further erosion of credit availability. Therefore, I am comfortable with the intervention in this case. However, I am concerned, as always, about the longer-term implications and possible unintended consequences. For example, we need to make sure that the new safety net does not encourage funds to take on inappropriate risk. If it does, we’ll have still another situation reminiscent of the Savings and Loan crisis of the 80’s.

We have to find a way to stop sticking the taxpayers with the losses associated with risk after someone else has taken the gains.

12/14/08 NOTE: "The Fed's answer" has been now been implemented. The link above describes the coverage limits as of December 2008.